Fiscal Cliff Solution for High Earners

No one likes more taxes. On Jan. 1 there will be 3.8% tax on investment income for high earners; however, there is a way to possibly circumvent that surcharge.

If the best columns give information the readers really need to know, this may be among the candidates for that award. It is short, but important. It provides options for protection against the potential investment income hike Jan. 1 that is exclusive to high earners.

The problem

On Jan. 1 there will be a 3.8% tax on investment income for most joint filers with an adjusted gross income over $250,000 and single filers above $200,000. That is, unless there is a resolution of the so called fiscal cliff; the combination of an increase in taxes and spending cuts.

A solution

Invest in municipal bonds to circumvent the surcharge. I chose Vanguard as an example because their charges to the client are among the lowest in the nation. Fidelity is similar.

Vanguard High-Yield Tax-Exempt (VWAHX) has a dividend as of Oct. 31 of 3.76%. It invests at least 80% of its assets in investment-grade municipal bonds and is rated overall five stars by Morningstar on a scale of one (low) to five (high). However, its risk rating is also hefty at five stars.

Vanguard Intermediate-Term Tax-Exempt (VWITX) has a dividend of 3.11% as of Oct. 31. It invests at least 75% of its assets in investment-grade municipal bonds and is rated overall four stars by Morningstar. Its risk rating is lower than VWAHX at three stars.

As a word of caution, each of these mutual funds has the potential to lose principal. The most recent was in late 2008 — VWAHX plummeted from 11.5 to 9.0, a drop of 22% (see below). At the same time, VWITX (not shown) dropped approximately 12.4%. The latter carries less risk, which is reflected in the lesser loss.

From Yahoo.com

For those that feel they can’t tolerate losses of principal (historically temporary), there are other options. One is the willingness to accept less return for greater stability. Vanguard Short-Term Tax-Exempt (VWSTX) is an example. In 2008, it lost approximately 1.3% of principal compared to the 22% and 12.4% for VWAHX and VWITX respectively at the same time.

Consistent with less risk, VWSTX has a lower dividend of 1.07% as of Oct. 31. It invests 75% of its assets in investment-grade municipal bonds. Its overall Morningstar rating is two stars, and its risk rating is the lowest possible at one.

In closing, I can’t help but notice that the prices of VWAHX and VWITX have been steadily climbing, which of course diminishes the dividend yield since the two are inverse to one another. This rise in price makes me think that others are thinking ahead and buying municipal bonds now. If enough people embrace this concept, purchasing these funds now then others like them may end up as a short-term bond market play.

Until President Obama and Congress show their hands, though, we are like pawns in a game. As I said in my recent column, “…we can’t control our government, which may make laws that don’t benefit us directly. But, we can manage our response…”